Monday, March 25, 2013

Implications of a collateral recovery

I wrote about the observed relationship between housing and startups here, where I suggested that "it is likely that housing plays an important collateral role for many entrepreneurs." A paper by Adelino, Schoar, and Severino finds more specific evidence of the notion that housing collateral and entrepreneurship are linked, so maybe I'm not crazy (which is good, since I've been working on a structural model of this stuff for over a year).

This is relevant since house prices appear to have bottomed nationally last year (surprise! Bill McBride nailed it). We'll see if the recovery continues, but it could loosen up collateral constraints for people at the extensive margin of entrepreneurship. Given the importance of startups for net job creation, better collateral might mean more jobs.

Adelino, Schoar, and Severino attempt to estimate the effect of shocks to housing collateral values on entrepreneurial activity. It's pretty difficult to pin down causal estimates of this relationship. They do it using an idea that probably a lot of people have had: Albert Saiz's estimates of housing supply elasticity. These have been used for many purposes; the idea is that they capture constraints on housing supply that are imposed by "exogenous" factors like geography and regulation. If local housing supply is inelastic, shocks to housing demand have large price effects; if local supply is elastic, shocks to housing demand have smaller price effects. If the supply elasticities don't directly drive outcome variables you care about, maybe you can use them to track the consequence of house price movements.

I spent some time thinking about using this instrument some time ago, but I concluded that I would have a hard time convincing myself and others that it is not related to entrepreneurial activity through channels other than house prices. That said, it may be as close as we're going to get to having the kind of exogenous variation we need for this question.

The authors find the following:

We show that leading up to the recession of 2008, areas with rising house prices (and increased leverage) experienced a significantly bigger increase in small business starts and a rise in the number of people who are employed in establishments with fewer than 10 employees compared to areas that did not see an increase in house prices. The same increase in employment cannot be found for large establishments in these same areas. . . . This asymmetric effect on small versus large only holds for instrumented house prices, which suggests that the non-instrumented part of the variation (which is the one that captures endogenous demand) mostly impacts employment at larger firms. This asymmetry points to the interpretation of the collateral lending channel as an important driver of employment creation in small firms.

This result holds within industries (including tradeables), and the effect is particularly strong for industries known to have higher external capital needs. Similar to the popular work by Mian and Sufi (I mentioned their stuff here), the authors estimate the magnitude of this channel's role in aggregate employment and find that "the collateral channel can account for 10-25% of the increase in pre-crisis employment, . . . while the demand channel explains about 40% over the same time period." Note, though, that this approach uses a somewhat unsatisfactory extrapolation from local to national data; as the authors note, general equilibrium effects and other stuff are not accounted for.

The analysis is done on County Business Patterns data, and the authors acknowledge that more can be done with firm-level data. Their house price data come from FHFA and are at the MSA level (as are the Saiz elasticity data). The housing supply instrument relies for its validity on being uncorrelated with entrepreneurial activity except through the collateral channel. I think this is a pretty tough standard to meet, but this may be an unavoidable limitation of research on this topic.

In any case, the results are highly suggestive and are consistent with similar results found elsewhere (that one uses time series identification and gives attention to firm age). I think it's really difficult to not believe that the collapse of housing collateral values is partly to blame for the collapse of startup activity we observe heading into the Great Recession.

If there are a lot of people that are sitting along the extensive margin of entrepreneurship but cannot enter due to collateral constraints, a recovery of house prices could be just what we need (and there may be intensive margin effects as well). Entry creates a lot of jobs; and while this job creation is short lived for many entrants (see here and here), it could get the job market moving again and improve the chances for the next few cohorts of entrants.